Discounted Cash Flow : An Income Approach of Valuation

Discounted Cash Flow Model

The potential earning power of a company is generally a paramount factor for valuation of share but there may be occasions, especially in valuations for compensation, where other considerations become relatively more important. In the absence of any other special motive, an investor is principally interested in a company’s ability to continue earning profits. The Income Approach indicates the value of a business based on the value of the cash flows that a business is expected to generate in future. This approach is appropriate in most going concern situations as the worth of a business is generally a function of its ability to earn income/cash flow and to provide an appropriate return on investment.

The Income approach includes a number of models/ techniques, such as Discounted Cash Flow, Maintainable Profits Basis, Dividend Discount Model, and others.

DISCOUNTED CASH FLOW (DCF)

Discounted Cash Flow model indicates the fair market value of a business based on the value of cash flows that the business is expected to generate in future. This method involves the estimation of post-tax cash flows for the projected period, after taking into account the business’s requirement of reinvestment in terms of capital expenditure and incremental working capital. These cash flows are then discounted at a cost of capital that reflects the risks of the business and the capital structure of the entity. 

Discounted Cash Flow is the most commonly used valuation technique, and is widely accepted by valuers because of its intrinsic merits, some of which are given below:

• It is based on expectations of performance specific to the business and is not influenced by short-term market conditions or non-economic indicators.

• DCF  is based upon expected future cash flows of a company that will determine an investor’s actual return. Based upon this it can be said that it is a very sound model.

• It is appropriate for valuing green-field or start-up projects, as these projects have little or no asset base or earnings which render the net asset or multiple approaches inappropriate. However, it is important that valuation must identify the additional risks in such a case (like project execution risk, lack of past track record, etc.) by means of an appropriate discount rate.

• Since DCF is based on cash flows rather than accounting profits, it is not as vulnerable to accounting conventions like inventory valuation, depreciation, etc.  as compared with the other techniques/approaches.

Though the Discounted Cash Flow model is one of the widely used models for valuation because of its inherent benefits, it still has its share of drawbacks. Major shortcomings of this model are as follows:

• It does not take into account several other factors, such as investment risk associated with opportunity cost, i.e. investments that could return greater cash flow yields would add an unrealized element of risk, unforeseen variations in future cash flow, and other non-financial factors.

• It is only as good as its input assumptions. Following the “garbage in, garbage out” principle, if the inputs – Cash Flow Projections, Discount Rate, and Terminal Value - are wide off the mark, then the value generated by using this model does not reflect the fair value.

Under DCF model, Cash Flow Projections, Discount Rate, and Terminal Value are three pillars based on which the valuation of shares is calculated.

Also read: Business Valuation: An Overview